It seems that all of a sudden everyone is talking about risk. The newspapers are screaming at us about the risk of contagion from the European crisis, the Australian Prudential Regulation Authority is introducing new standard risk measures for superannuation funds, Dodd-Frank legislation in the United States is all about risk management – the list goes on and on.

But what is risk? The best definition is that it’s the collection of all those things that give rise to the possibility of investors failing to achieve their mission. Risk is therefore multidimensional and means different things to different people.

Mission control

As a general rule, investors do not view risk through the lens of impairment to mission. Because of this, not enough attention is given to determining and articulating mission.

‘Mission’ goes to the heart of what we do. It says what your long-term value proposition is, what you do for your customers and what you are trying to achieve. Only when a firm truly understands its mission can it then understand risk.

Everyone in the airline industry understands its mission: to fly passengers safely from point A to point B. There may be peripheral commercial aspects to that, such as offering a low-price business model, but at the heart of the airline industry there’s a very simple mission. Moreover, everyone understands it and the potential impairments to it. Therefore, they understand risk and take it very seriously.

Around the world, thousands of flights take off and land successfully at destinations every single day. The aviation industry has had a lot of time to understand the nature of the risks it faces and to develop sophisticated systems to ensure that it consistently achieves its mission.

The consequences of mission failure are ever-present. Failure is immediately apparent, sensational and not easily forgiven. So it is not surprising that the industry achieves its mission almost all the time.

Managing risk in flight

The investment industry can learn a thing or two from how this is done. In the airline industry, risk is well understood and monitored; personnel are trained to anticipate it and to respond to it calmly in a well rehearsed and carefully thought-out fashion. Contingency planning, scenario testing and stress testing are constant. Sophisticated technology is used to help the industry achieve its mission, supported by regulation that is almost exclusively focused on safety standards and risk management.

There are five key planks in the airline risk-management framework:

1. Redundancy – There are two pilots, multiple engines, backups for all major systems and planes carry excess fuel.

2. Monitoring – A journey plan is created and filed, the pilots monitor a multidimensional dashboard; air- traffic control monitors the flight and the pilots monitor each other.

3. Technology – Collision-avoidance and automatic stabilisation systems, computers and communications systems monitor flights and crew.

4. Regulation – Airlines and staff are licensed, audited and conform to rule books that govern maintenance of their equipment.

5. Training – Large amounts of money are spent on crew testing, training and teamwork development, scenario planning and emergency drills. It is expected that this will result in a rational response under pressure.

This is an industry that has been forced by circumstances to manage risk well. Participants understand the mission and the risks explicitly.

Risk is friendlier to investment

The investment industry has it better than the aviation industry for two main reasons. First, the consequences of failure are usually not as visible, severe or sensational. Secondly, risk – which is wholly negative in the aviation industry – can be used to advantage in the investment industry. While there is no reward for seeking risk in the airline industry, there is (or should be) reward for risk in the investment industry.

The paradox of risk in investment is that investors must take some risks to create wealth. Successful investing requires investors to understand the risks they are taking, to take risk only when it is economically justifiable and to maximise the expected reward for every unit of risk they choose to take. Axiomatically, risk is friendlier to the investment industry than it is to aviation. But this is no excuse for us not understanding risk and mission.

While there is no reward for seeking risk in the airline industry, there is (or should be) reward for risk in the investment industry.

We should be thinking about ‘adaptive buffers’ – mechanisms, financial and non-financial, that can support an investor through adverse periods. Here’s how an airline approach might look in the investment industry:

Redundancy – We could have explicit capital buffers, tail-risk hedges, higher super-fund-member contributions and multiple engines of return.

Monitoring – A journey plan, a risk ‘dashboard,’ early-warning systems and using dynamic strategic-asset allocation to alter risk exposures in response to changing circumstances.

Technology – Member profiling, better modelling and better communications systems.

Training – Better scenario planning, more robust stress testing and emergency drills to teach stakeholders to behave calmly in times of duress.

Institutional investors should spend more time defining and articulating their mission, and then embed this mission into everything they do.

It is arguably rational for a superannuation fund to have a mission that says “We’re in the business of creating savings products and selling as many as we can so we can be competitive.” That is a sensible mission in the retail financial-services industry. If that mission is understood, the risk management framework will be focused on how the fund’s products compare to competitor products.

On the other hand, a traditional mission for a superannuation fund might say “We aim to provide members with financial security in retirement”. This is very different to the previous one, so the framework for managing risk will be different.

My call to the industry is to think about risk as the possibility of impairment to mission. Nothing matters more to risk than mission – if you don’t understand your mission then it’s certain you don’t understand risk either.

Graeme Miller is director of investment services at Towers Watson. 

 

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